Economic Survey of Korea 2005: Getting the most out of public-sector decentralisation

Fiscal rules are needed to ensure sound financial management by local governments…

One aspect of maintaining a sound fiscal position is to ensure the accountability of local governments, which account for almost half of total government spending in Korea. With the abolition of the system requiring central government approval of each local government bond issue, fiscal rules need to be adequate to ensure sound financial management. This should include increased transparency concerning contingent liabilities, particularly in regard to public corporations, while reducing the reliance of local governments on borrowing from the public sector.

… accompanied by an overhaul of the local government tax system…

Fiscal responsibility of local governments should also be enhanced by increasing their taxing powers through a broad reform of the local tax system.

The current system, which includes 16 different taxes, should be simplified by eliminating those that generate minimal revenue but increase complexity and administrative costs.

Local governments should be encouraged to exercise their existing power to change tax rates, which has been little used despite being allowed for 11 local taxes.

The high level of taxes on property transactions, which account for 40% of local government tax revenue, should be reduced as they create lock-in effects, thus reducing the efficiency of land use, and are only loosely related to the demand for local government services.

The government should accelerate its plan to boost the effective tax rate on property holdings from 0.1% at present to 1% by 2017 by bringing the tax base closer to market levels, as this would discourage speculative activity and encourage efficient land use.

The net effect of reforms should be to increase local government tax revenues through higher property holding taxes and, if necessary, other taxes that achieve the objective of enhancing local autonomy and accountability.

However, increasing local government reliance on tax revenue is likely to aggravate regional imbalances, given that per capita tax payments in the capital region are about 60% higher than in the rest of the country. Achieving the second objective of limiting regional imbalances requires that the devolution of taxing power be accompanied by sufficient transfers from the central to poorer local governments to ensure adequate public services throughout the country. The formula currently used to calculate such transfers should be made more transparent and simple, while reducing arbitrary adjustments. The central government should make clear that local government efforts to boost tax revenues will not be offset by decreased transfers.

… and increasing spending autonomy

The government should transfer responsibilities to local governments to increase efficiency and enhance the capacity of the public sector to meet the needs of local citizens. Effective decentralisation requires establishing a clear division of responsibilities between levels of government. The capabilities of local governments, which have been limited to acting as agents of the central government, should be expanded to handle greater responsibilities. Currently, there exist separate local governments responsible for primary and secondary education. The general local governments should have more influence on education, while providing more support, through stronger linkages with the local education authorities, with a final aim of merger. Autonomy should also be expanded by changing earmarked transfers to block grants, where appropriate, and relaxing the conditions attached to earmarked transfers to allow greater flexibility for local authorities.

Market-friendly polices should be used to achieve goals on regional balance and pollution control

Developing more dynamic and autonomous local governments may have a positive impact on the government’s goal of achieving more balanced regional growth. Despite the measures to reduce concentration in the capital region by regulations limiting new construction, the region’s share of population and economic activity has risen to nearly half. The easing of these regulations on small and medium-sized enterprises (SMEs), venture businesses, foreign-invested companies and advanced-technology firms is appropriate as it allows firms to follow through on investment plans. At the same time, it is necessary to increase reliance on economic instruments aimed at offsetting externalities resulting from concentration in the capital region, notably congestion and pollution. With air pollution in Seoul among the most severe in the OECD area, the government should follow through on the introduction of a cap-and-trade system in 2007 to limit industrial emissions. In addition, the government launched a “regional innovation plan” aimed at creating clusters of government research institutes, firms and universities in various locations outside of the capital region. The location of such clusters should be chosen transparently on the basis of clear criteria. Given the importance of innovation in sustaining growth, policies to promote innovation should focus primarily on the objective of fostering national productivity growth rather than on regional development.

For further information please contact the Korea Desk at the OECD Economics Department at webmaster@oecd.org. The OECD Secretariat's report was prepared by Randall Jones, Yokoyama Tadashi and Yongchun Baek under the supervision of Wilhelm Leibfritz.